Ut-oh! Is China starting to blame the US for its currency losses?

It is commonly argued that growing economic ties tend to create common interests that will reduce tension between nations (see FT’s Alphaville). The enormous amount China has lent to the US — a total that the US data (which tends to underestimate Chinese holdings) now puts above $1 trillion — will, according to this view, prevent other sources of conflict from getting out of hand.

Alas, relations between creditors and debtors are rarely quite so free of tension. Creditors want to get paid back in full. Debtors would rather pay back at little as possible.

Mei Xinyu, a senior researcher under the Chinese commerce ministry writing in a personal capacity for the Shanghai Daily, argues that China needs to put pressure on the US at the Strategic Economic Dialogue to do more defend the dollar. With the dollar at 1.60 against the euro, it isn’t hard to see why.

Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China.

“The negative results of the US dollar’s decline are evident: the rising prices of all primary products, the intensified pressure on inflation globally, the confusion in the settlement of international transactions, etc. Worst of all, this is the US’ disguised way of avoiding paying off its debts to foreign countries.

It should be noted that the US is the biggest debtor country in the world.
… By the end of 2006, the US’ accumulated net debt overseas hit US$16 trillion. As most of the debts were calculated in US dollars, the US is actually welshing on its debts malignantly by allowing the devaluation of US dollars. Since China is the country with the world’s biggest foreign exchange reserves, most of which are calculated in US dollars, China thus is hurt most greatly from the US dollar devaluation.”

One man’s exorbitant privilege is another man’s disguised default. Just think what might have happened it CITIC had invested in Bear and China had gotten back depreciated pennies on its initial dollar … More follows

What’s more, Mei Xinyu’s argument isn’t entirely wrong. The value of China’s investment in the US — an investment that is probably roughly equal to a third of China’s GDP (assuming the US data slightly understates China’s true holdings) — will almost certainly fall in RMB terms. And unless something changes, the US isn’t going to direct its macroeconomic policies towards maintaining the dollar’s external value. Bernanke’s job is price stability and full employment in the US — not protecting the Chinese purchasing power of the dollars that China has lent to the US.

But Mei Xinyu’s argment is still a bit off. China invested in the US knowing quite well that the US wasn’t committed to defending the dollar’s external value. It invested in the US even though the US had a large trade deficit. It invested in the US even though the IMF indicated the dollar was overvalued and would tend to depreciate over time. It invested in the US even though a gloomy American academic and a former Treasury staff economist quite explicitly warned that China would lose money on dollar holdings back in 2004.

Mei’s complaint, in other words, should be directed in part at China’s own policy makers. When they bought long-term US dollar-denominated debt they took the risk that the dollar would depreciate over time. They effectively gave the US the option to pay China back in depreciated dollars. What’s more, they didn’t charge a premium for the option. That was China’s own choice. China wanted to keep the RMB down even if that meant over-paying for US assets.
It has proved to be quite a consequential choice.

Measured by the funds it has available to lend abroad ever year, China is now the world’s biggest creditor. Most creditors tend to lend to the rest of the world in their own currency. That is what the US historically did, back when it was a creditor. Latin countries seeking financing from US investors promised to repay in dollars, not pesos (a promise that created problems of its own, problems well-documented by Dr. Hausmann). That is what Europe does as well — an awful lot of the external debt of the Eastern European countries is denominated in euros. China, for complicated reasons, has decided to lend to the US in US dollars and to lend to Europe in euros and pounds. China’s European lending – incidentally — could prove to be as risky as lending to the US in dollars; SAFE and the CIC are really over paying for euros.

As a result, China is bearing the exchange rate risk. And the size of China’s fx position is now quite large.
This exposure was a consequence of China’s decision to hold more foreign currency reserves than it needs in an effort to hold its currency down. It was China’s own choice. Still, I suspect that as the financial costs of China’s policy become more apparent, more and more Chinese commentators will argue that the US — and perhaps in time Europe — have failed to live up to their side of the bargain by failing to do enough to defend their respective currencies.

That strikes me as a recipe for future trouble.

Opinions expressed on CFR blogs are solely those of the author or commenter, not of CFR, which takes no institutional positions.

68 Comments

Posted by DCApril 22, 2008 at 12:28 pm

The Chinese are 100% right. The monetary value of the US dollar plunges almost daily. The Bernanke Fed’s reckless and irresponsible monetary policies have triggered a run-up in commodities prices which is driving up the cost of everything from corn to oil. Last week, former Fed chairman Paul Volcker took the unusual step of publicly chastising Bernanke in a speech he gave to the Economic Club of New York. Paul Volcker noted last week that we are already in a "dollar crisis". According to Paul Volcker, the primary and only responsibility of the Federal Reserve is the "preservation of the monetary value of the US Dollar and everything else is none of the business of the Fed". Bernanke’s problem is that he is so easily manipulated by Wall Street banksters that global investors are becoming afraid to entrust their assets to the US securities markets and the US dollar that even CNBC’s Kudlow refers to as the "American peso". Inflation is roaring and Bernanke is only paying lip service to the serious problem. It is time to fire Bernanke for gross incompetence and bring back Volcker from retirement.

Posted by shrekApril 22, 2008 at 1:05 pm

Here is a unthinkable concept for the chinese. Develop a domestic economy! Oh wait. You cant do that when you’re a corrupt kleptocracy.

Posted by AnonymousApril 22, 2008 at 1:14 pm

It seems the United State misinterpreted China’s altruistic motives for purchasing all that US debt. They weren’t buying it as an investment or to keep their currency artificially undervalued, they were selflessly lending it for the US government as a friendly favor. How foolish of us to think otherwise…

Also, perhaps someone should send copies of “Confessions of an Economic Hitman” to the leaders of every developing world nation? The book makes clear what the true mandates of the Washington Consensus controlled IMF are for Neo-liberal globalization. HINT: it isn’t to actually “help” developing countries become self-sustaining economic models. The massive propaganda attacks by the US mainstream media to discredit the Chinese prior to the Beijing Olympics are an absolute disgrace. Fake Videotape and falsified images were used by CNN and other US news organizations.

Chinese policy makers could easily arrange for a massive one-off appreciation of the Yuan and they have plenty of other tools besides. Beijing is willing to lose money and tolerate the erosion of its "loans" to the USA in exchange for the easy market access and its export-led development model which creates as many jobs as possible, quickly. After all their mandate is just the same as Bernanke’s – keep unemployment at manageable (social stability) levels. But as the financial markets mature in China there will be more calls to do something about it. Surely the surge in agricultural prices (rice in particular) are worrying Chinese money managers.

As for Shrek’s comment, consumer demand remains very strong in China – up over 20% in the 1Q and if you’ve ever been to big Chinese cities you’d know the push is to create an American style consumer culture. But the effects are generational – the big box stores and shopping malls are still empty most of the time, at least from what I see, as the older generation won’t adjust to shopping that way, preferring the individual shops and markets. Over time it will definitely develop and maybe one day Chinese demand will again enrich American exporters as it did in the 19th Century.

Posted by shrekApril 22, 2008 at 2:04 pm

Consumer spending implies wealth. Wealth leads to influence and power which is a threat to the PBOC.

Posted by TortoiseApril 22, 2008 at 2:06 pm

Brad, excellent article. One thing. You say: “China, for complicated reasons, has decided to lend to the US in US dollars and to lend to Europe in euros and pounds.” I do not think the reasons are so complicated. China had decided to support/subsidize exports … Well, guess what. Subsidies can be expensive.

If China wants, they can stop new subsidies NOW by balancing the balance of external payments.

Posted by AnonymousApril 22, 2008 at 2:54 pm

This is too rich.

How can China intervene to buy $ 1 trillion above market, then manage a declining peg, and then complain about the dollar’s decline?

Setser: Most creditors tend to lend to the rest of the world in their own currency. That is what the US historically did, back when it was a creditor. Latin countries seeking financing from US investors promised to repay in dollars, not pesos (a promise that created problems of its own, problems well-documented by Dr. Hausmann).

Let’s see what catchy name Ricardo comes up to brand this one.

There does seem to be a worrisome nationalist strain in China, so I think your worry is valid.

As a counterpoint though, the Bank of Japan seems to have escaped domestic criticism. Perhaps in China it will be the most visible investments–CIC in Blackstone–that will draw the most ire.

Posted by bsetserApril 22, 2008 at 3:23 pm

Japan also hasn’t really taken large losses. Positive carry. And it bought at around yen 100 back in the day —

I think the relevant comparison would be not with japan now, when it is already developed and its exchange rate is roughly where it likely will stay over time (recognizing this is very rough and the yen is now very weak v the euro) but rather if japan had built up huge reserves before the yen appreciated from 360 to the 100s …

The "nationalist" story line that the US screwed China on its dollars is fairly easy to construct, and of great concern to me.

Posted by KnotRPApril 22, 2008 at 3:25 pm

Shoot. We’re gonna need about a billion more "I’m with Stupid" T-shirts.

(Vendor financiers are suprised their customers aren’t good for it? I don’ t think so. Mercantilism has a purpose, but it’s not to make money by lending money)

Posted by dmg555April 22, 2008 at 3:51 pm

Brad:

This is a bit off the immediate subject, but I would enjoy your response.

I recently listened to the Canadian tv Roubini interview and was not surprised by his contention that the U. S. is heading for an 18 month recession of major consequence as opposed to a minor 6 month correction. What I found alarming, however, were his suggested remedies; which called for massive governmental expenditures including the purchasing of defaulted housing stock. His rational was that spending billions now will prevent spending trillions later. Adding defaulted housing stock to the growing list of new assets the Federal Reserve is accumulating, or the Social Security System, which is where my guess these new assets might go, will definitively increase our already growing deficit and further depress the dollar as your last blog points out. To a monetarist, this is Keynesian economics gone haywire. Aren’t the markets themselves better at finding a true clearing price than the government? How do we know whether the housing stock will be bought at par, slightly below par, or at a true market rate?

Residential real estate should not be used as an ATM to supplement consumer spending, as this current contraction reveals. I am reminded of the Buffett analogy that once the tide recedes, (which is a natural event by the way, as are zeniths and nadirs in various assets classes) we get to see who’s wearing swimming trucks.

If the government runs to the rescue of the over leveraged home owner, which I maintain is minor, compared to our future problems, how will it ever deal effective with the much larger baby-boom Social Security and Medicare crisis, which is clearly delineated on page 28 of the 2006 Financial Report of the U. S. Government.

Where do you stand on the extent of the Governments new role as buyer of last resort in what from my perspective are normal market fluctuations? Aren’t markets the most efficient pricing mechanisms and shouldn’t true pricing information determine where capital should be allocated.

April 21 (Bloomberg) — To hear Kevin Phillips tell it, the U.S. is a world power on the skids, an overstretched empire slumping toward the fate of Hapsburg Spain, the maritime Dutch Republic and imperial Britain.

The culprits: Wall Street and Washington.

The former Republican strategist lays out his harsh case in “Bad Money,” an update of his 2006 bestseller, “American Theocracy,” which warned that the U.S. was dangerously dependent on debt and oil. Events have so far vindicated his views.

Posted by EstragonApril 22, 2008 at 4:08 pm

When a debtor defaults (implicit or otherwise), the outcome (absent bankruptcy) is generally the assignment of assets and/or garnishment of future earnings by the creditor.

I suspect the endgame here involves the transfer of US productive assets and technology to its creditors. In the case of China, that may not be a totally unreasonable strategy, as the technology transfer in particular is likely to be important as it moves up the value chain.

Where this may really get ugly is if, as is reasonable to expect, the US government attempts to thwart the process on national security grounds.

Posted by HousingDepressionApril 22, 2008 at 4:42 pm

From Paul Krugman

April 22, 2008, 1:49 pm

Ho-hum day on the markets

Eh, oil’s above $119, the euro’s above $1.60, and the scramble for safety has sent the yield on one-month Treasuries down to 0.59%. Nothing to see here.

Seriously, these are wild and crazy times.

Posted by tApril 22, 2008 at 4:55 pm

Not really a surprise though is it.

Imagine the parallel universe:

"China pleased with the US over its currency losses"

Doesn’t really work.

Maybe there is a culture gap. In many dollar creditor countries, there is no bankruptcy, you just end up in prison.

Posted by GloomyApril 22, 2008 at 5:14 pm

CHECKMATE

This is what Mike Shedlock and others refer to as the checkmate scenrio for Bernanke. If you leave rates alone or lower them, the Chinese dump the dollar and armageddon will follow. If you raise rates, the economy falls off a cliff and armageddon follows.

Posted by TwofishApril 22, 2008 at 5:24 pm

dmg555: What I found alarming, however, were his suggested remedies; which called for massive governmental expenditures including the purchasing of defaulted housing stock.

Personally, I think that is a very bad idea. It’s rewarding bad behavior. The thing about lowering interest rates is that it doesn’t particularly reward people that went overboard during the housing boom.

The only reason I can think of for purchasing housing stock is if there were urban renewal issues (i.e. defaults and foreclosure causing a pocket of crime and poverty). Even in that situation, the government shouldn’t pay cents on the dollar for property.

One other problem is if the government buys housing stock, what is it going to do with it. Banks and governments make bad landlords. The government can resell the property to real estate developers, but then the question is why shouldn’t the developers buy the property themselves.

dmg555: Aren’t markets the most efficient pricing mechanisms and shouldn’t true pricing information determine where capital should be allocated.

Yes, but markets can easily get themselves into positive feedback cycles which cause everything to freeze. However, I don’t think we really are in that situation in most real estate markets.

Posted by TwofishApril 22, 2008 at 5:26 pm

Gloomy: If you leave rates alone or lower them, the Chinese dump the dollar and armageddon will follow.

China is not going to dump the dollar.

Posted by plschwartzApril 22, 2008 at 5:52 pm

The return of the Middle Kingdom is at hand. We rode down the Nile on the back of the Chinese Crocodile. Has China really changed from its attitude to Barbarians? From its behavior to Westerners before the Opium Wars.

As I am sure you know Brad, there is a strong line drawn first between family/non-family. Family first, (Madame there is no second.)

Then that attitude is the model for your village up to your nation.

I was told years ago that the key to understanding China was "the Art of War". I still find that advice most useful. They had a strategic position which resulted in them amassing dollars. Now that they have this trillion it now can be used for another strategic move.

I think the attacks on the Olympic Flame has upset them as much as Jesse Owens did in 1936 Berlin.

I fear there is more then a little similarity between these two Olympics

Posted by RealThinkApril 22, 2008 at 6:17 pm

@Brad

"Bernanke’s job is price stability"

Then he botched it. Big time.

"and full employment in the US — not protecting the Chinese purchasing power of the dollars that China has lent to the US."

Then neither is Bernanke’s job to protect the purchasing power of the USDs that OPEC countries have received for their oil. Which makes decisions such as this seem entirely logical:

"Saudi Arabia’s King Abdullah said he had ordered some new oil discoveries left untapped to preserve oil wealth in the world’s top exporter for future generations, the official Saudi Press Agency (SPA) reported.

"I keep no secret from you that when there were some new finds, I told them, ‘no, leave it in the ground, with grace from god, our children need it’," King Abdullah said in remarks made late on Saturday."

"Local leaders have repeatedly said that they feel an obligation to preserve some of their natural resources. These feelings must be intensified when their recent production has been sold for US dollars which have depreciated by 25% or more against other strong world currencies over the last four years."

This is exactly Peak Oil Now. Implying among many other things that the pursuance of the second of Bernanke’s objectives will be futile. And dangerous.

Posted by HZApril 22, 2008 at 7:28 pm

Everyone is right that China can’t be complaining about exchange rate in good faith. It will have a valid complaint however if Fed changes its monetary policy to have higher long run inflation target. But I am also pretty sure that such a policy will cost US a lot more in the long run that what it can get from devalued debt so I doubt Fed would voluntarily pursue such a policy.

I totally share Brad’s concern. As an expatriate in China, I can see the growing propensity of Chinese transference of their own problems to foreign countries, simply because authorities are more permissive when it comes to criticizing foreigners. This is true for any matter.

Besides, Chinese just don’t know how to handle multilateral issues just the way we do; I mean, of course, they are able to, but they lack of willingness to adapt to these way of thinking, just because they’re not theirs. The problem is we, westerners, have set up the standards without China because China simply refused (and is still reluctant)to be part of the normative process. Someday we’ll be forced to say bluntly that a big deal of their current situation, their persistant relative backwardness, is the consequence of their own political choices. This share of responsability, they are obviously not ready to take. At the same time, they are getting powerful, at least economically speaking. All this makes me not less worried than Brad about possible future troubles.

Posted by TwofishApril 22, 2008 at 9:48 pm

plschwartz: The return of the Middle Kingdom is at hand. We rode down the Nile on the back of the Chinese Crocodile. Has China really changed from its attitude to Barbarians? From its behavior to Westerners before the Opium Wars.

One thing that annoys me is when people argue that China acted in manner X in 500 BC or 1850, therefore it has to act in the same way in 2008. Especially since it often turns out that China *didn’t* act in that way in 500 BC or 1850.

For example, one of the reasons Qianlong was so tough against Lord Macartney was that he had just finished a long war in Central Asia and was not about to look weak.

plschwartz: I was told years ago that the key to understanding China was "the Art of War". I still find that advice most useful.

Rubbish. It’s like thinking that you can understand the West by reading Clausewitz.

plschwartz: They had a strategic position which resulted in them amassing dollars. Now that they have this trillion it now can be used for another strategic move.

No it can’t. How China got to the point of amassing such large currency reserves is an interesting story, but like most economic policies in the last 25 years, it involved stumbling from one thing to another.

Posted by J.April 22, 2008 at 9:53 pm

DC;

Finance, i.e. rentier, capitalism can be the form which grows out of an overaccumulated industrial capitalism; it is the latter’s attempt to escape what are inherent limits and an attempt which generates masses of fictitious capital that nevertheless require valorization, hence demands perpetuation of that which it struggles to deny. It is a false escape yet for a time proves able to provide spectacular illusions, even to the point that these become commonly accepted.

Posted by TwofishApril 22, 2008 at 10:05 pm

Yuk: simply because authorities are more permissive when it comes to criticizing foreigners. This is true for any matter.

Public criticism and private criticism are very different things.

Yuk: Besides, Chinese just don’t know how to handle multilateral issues just the way we do

Who is we? China is perfectly willing to handle multilateral issues, however multilateral doesn’t me "do what the West tells it to do?" There’s got to be a negotiation and there has be to push back.

Yuk: I mean, of course, they are able to, but they lack of willingness to adapt to these way of thinking, just because they’re not theirs.

China figured out about 120 years ago that to survive as a nation it had to adopt large amounts of Western ideas. If there is a Western idea that makes China richer and powerful, then sure, China will take it. If it makes China poorer and weaker, then what is the point?

Yes, China does act in its own national interest, but when push comes to shove, what country doesn’t?

Yuk: The problem is we, westerners, have set up the standards without China because China simply refused (and is still reluctant)to be part of the normative process,

WTO, UN peacemakers in Lebanon, cooperation over North Korea says that you are wrong. The problem is that China is simply not willing to be part of a multilateral process if multilateral means that the West tells China what to do, and I don’t see anything wrong with that, and China really doesn’t have that much interest in telling the West what to do.

Yuk: Someday we’ll be forced to say bluntly that a big deal of their current situation, their persistant relative backwardness, is the consequence of their own political choices.

China’s relative backwardness is because of a century of civil war and political instability followed by being ruled by an insane and economically incompetent dictator for about 30 years. Also the stupid economic policies that Mao followed were Marxist which wasn’t inventing in China.

But since 1978, China has been rather well, and one of the reasons for not agreeing to everything that the West wants China to do is that at some very crucial moments, China went against the Western consensus and it worked better.

Posted by GuestApril 22, 2008 at 10:06 pm

I agree with Brad and most you, but it will be mostly talk by China until after the Show Case of the Summer Games. Then look out and as some one pointed out they have buyers that can take the place of out of money Americans.

jo6pac

Everything is on schedule, please move along.

Posted by donApril 22, 2008 at 10:11 pm

"I actually suspect that emerging market central bank activity in the currency market helped create the conditions that has prompted industrial country central bank activity in the credit markets."

If you are saying what I think you are saying, that story is very relevant to the present discussion. And I think it is exactly right.

One could argue, I think, that the Chinese currency strategy is equivalent to an unauthorized appropriation of foreign aid, from us to them. China’s growth is responsible for a dramatic decline in global income inequality. Jeremy Bentham, might view this as a good thing.

Posted by bsetserApril 22, 2008 at 10:59 pm

2fish: " One thing that annoys me is when people argue that China acted in manner X in 500 BC or 1850, therefore it has to act in the same way in 2008. Especially since it often turns out that China *didn’t* act in that way in 500 BC or 1850."

Maybe I have been spared your wrath because I lack enough knowledge of the full sweep of Chinese history to even try to make comparisons …

I agree that China kind of stumbled into a policy adding (gulp) perhaps $200b a quarter to its reserves to control its pace of appreciation. I am not sure there was ever a decision to this — it fell out of a series of short-sighted decisions not to move faster on the rmb (whether by deciding not to revalue until 05, deciding only to move 2% then, deciding to keep the pace of appreciation slow for some time then after or recently now allowing the rmb to move v the $ at a pace fast enough to offset the $’s slide v euro). Lots of US business leaders think China’s leaders are motivated by the long-view. I am not so sure — on the exchange rate issue, I have seen a lot of decisions that have the character of avoiding big decisions in the hope the problem will go away.

That said, I am sympathetic to the point gloomy made – namely so many things that couldn’t happen have already happened that it doesn’t seem prudent to bet everything on the assumption that the existing relationship (financial relationship) with China will remain stable forever.

Posted by bsetserApril 22, 2008 at 11:09 pm

yuk — the tendency to blame others for your own decisions that don’t work out is universal. We in the US are not immune. I think part of the strong reaction against the savings glut hypothesis stems from the fact that it suggests that the US deficit stems not from US excesses (too much borrowing) but others’ excesses (too much savings). I happen to think the theory is true — savings outside the US has gone up, and us excess borrowing has yet to push rates up. But the argument does have the character of deflecting responsibilty for what many see as a US problem abroad.

And to be clear, the "Savings glut" and the associated fall in interest rates on safe US assets arguably did push many private investors to take more risk. But the current crisis also stems from many policies that are "made in the US". our failure to adopt an energy policy (European and Japanese cars go twice as far on a gallon of gas as US cars, on average) played some role in the rise in oil prices. Our banks failed to set aside enough capital (even when it was easily available/ they had lots of spare cash/ were doing buybacks) to cover the risks they were taking. Our regulators allowed a lot of risk to be transferred to affliated sivs, and thus not counted against bank capital. Our ratings agencies made a series of bad calls. Our entire financial system seems to have underestimated the risk of a correlated nationwide housing crisis/ housing price fall. And so on.

All that said, I worry a bit that no one in china seems to feel responsible for the decision to have built up way more reserves than china needs, and thus no one feels responsible for the likely losses on those reserves as the RMB rises. In part that is becuase there probably wasn’t a decision to take China’s reserves from $500b in late 04 to close to $2 trillion (counting all the hidden reserves of the banks/ the cIC) now, only a series of decisions not to allow faster currency appreciation which had that effect. As a result, i worry that China’s currency losses will be a surprise, even though they shouldn’t be. One consequence of persistently intervening on one side of the market is that the market will likely move sharply against you when the intervention ends …

Posted by ScottApril 22, 2008 at 11:09 pm

Brad,

As you say, the idea that the US is to blame for exchange rate losses on China’s dollar Treasury holdings is ludicrous. Perhaps this is the start of a propaganda campaign to set the US up as the villain when China’s economy tanks due to the inevitable collapse of hypergrowth.

Posted by ScottApril 22, 2008 at 11:23 pm

Brad,

Re 23:09:53…I certainly hope that Chinese financial authorities are not surprised by the potential foreign exchange losses they now face. That would suggest that they are not competent to intelligently manage their economy (to the extent that that is actually possible). I feel that, contrary to your assertion, that China chose to accept the currency risk as an issue to be dealt with much later so that the country could realize massive economic growth. Perhaps the leaders in charge now figure on letting their successors suffer the political fallout from massive fx losses.

Posted by HZApril 23, 2008 at 12:08 am

Brad,

I think the vast majority of Chinese don’t know or care about the nominal loss of the reserve in exchange rate (unless it is sensationalized as an one-sided loss). Unlike oil from OPEC, labor can not be stored. What is the opportunity cost of not having the foreign investment and export industry? The big problem is of course to not build up a robust domestic demand fast enough. But without all the foreign investments (that were primarily interested in exports in the beginning) and exports there wouldn’t have been a virtuous cycle to build up domestic demand in the first place. Suppose China falls back to the growth rate of India, what would have been the loss of GDP? I suspect in comparison the exchange loss is a lot smaller. Sacrificing the environment for export (and domestic demand) is also a much bigger loss — though not explicitly accounted for, I suspect.

And lastly, dollars are not worthless. As of now China could afford to buy more education, technology, health care, and reimport brain drain etc. There are plenty of things US can still export.

Posted by HZApril 23, 2008 at 12:11 am

"Perhaps the leaders in charge now figure on letting their successors suffer the political fallout from massive fx losses."

Please educate us on what these fallouts might be.

Posted by AnonymousApril 23, 2008 at 12:15 am

"And to be clear, the "Savings glut" and the associated fall in interest rates on safe US assets arguably did push many private investors to take more risk."

Maybe it was the foreign portfolio glut of low risk assets that created a scarcity effect in them elsewhere. This prodded the structured finance boom to attempt to manufacture low risk assets from high risk ones. Private investors weren’t necessarily pushing to take that much more risk, just the next lowest risk. At least they thought it was low risk, given the very low yield pick up.

Posted by LoganApril 23, 2008 at 1:26 am

Brad,

Just wanted to add that these Chinese arguments blaming the US for currency losses are nothing new- Fan Gang, the current academic member of the PBOC Monetary Policy Committee, for example, has been making similar claims since 2004, as I recall. These arguments also surfaced visibly surrounding the last round of the US-China Strategic Economic Dialogue in Beijing in December 2007, and Chinese economists are now roundly blaming dollar depreciation for the yuan’s depreciation against the euro, as the Europeans are coming to Beijing at the end of this week for the first round of the EU-China High Level Mechanism (basically equivalent to SED), and China will attempt to answer their criticisms by deflecting blame onto the United States.

I would agree that there appears to have been no well-planned Chinese decision to accumulate foreign exchange reserves in these proportions; there was an initial decision to avoid rapid appreciation of the renminbi, and since then, the Chinese government has been trying to manage the consequences in various ways (sterilization, RRR hikes, export tax rebate cuts, the creation of the CIC, cutting short-term foreign debt quotas, etc.), only to see the reserves keep building up. Capital inflows of this scale are an unprecedented problem for Chinese policy-makers, and as a result, it’s difficult to hone a political consensus for a particular course of action.

Posted by NicolasApril 23, 2008 at 1:33 am

By the way China and the rest of the world do not have much respect for what the U.S. government monetary policy is all about and rightfully so. China is not the problem. The U.S. is its own worst enemy. For all the flag waving rhetoric there has never been such a debtor nation in the history of the world. The U.S. dollar should be strong instead of the deliberate debilitation by the private interests that run the currency. The world is no chump and is not blind.

Posted by PhilipApril 23, 2008 at 2:21 am

There are three ways out of this debt – the debtor repays (trades its way back to solvency, which doesnt seem credible) – the creditor converts the debt into assets (reposesses the US house, which doesnt seem politically acceptable) or inflation removes the problem. The latter seems the most likely scenario.

Posting from the UK – one of the very few sane things our prime minister has done has been actively to encourage Chinese investment into the UK. The only trouble I can see is that the Chinese will most likely have to deliver USD for these GBP/EUR assets – so will take a loss at the point of conversion; but that loss will be nothing as compared to when global inflation has taken hold.

"For all the flag waving rhetoric there has never been such a debtor nation in the history of the world."

Every debtor needs a creditor.

But I’d agree with you that America embraced an ideology (Hey, big trade deficits! no problem! it’s because foreigners are positive about America and want to invest here!) untempered by common sense.

Posted by AnonymousApril 23, 2008 at 8:01 am

Seeing as the Chinese dollar reserves are somewhere in the neighborhood of 2 – 3 times those of the Federal Reserve (especially since the BSC aftermath) should we not soon expect a ‘COMC’ to defend the dollar?

Posted by AnonymousApril 23, 2008 at 8:04 am

“I think part of the strong reaction against the savings glut hypothesis stems from the fact that it suggests that the US deficit stems not from US excesses (too much borrowing) but others’ excesses (too much savings).”

Consider the same imbalances under two interest rate scenarios. When interest rates are “low”, there is a savings glut. When interest rates are “high”, there is something else (Investment glut? Consumption glut? What is the flip side scenario to the savings glut?).

First, who sets the magic inflection point for interest rates when a savings glut suddenly becomes whatever its opposite is? If the condition is defined according to interest rate levels, there must be some interest rate level at which the condition changes over to its opposite. What interest rate level determines this judgment? And who defines this rule?

Second, the fact that there is a regional savings glut is trivial. This is simply a fact of the direction of the regional imbalance. To this extent, the notion of a savings glut is redundant – it’s just another way of identifying a current account surplus (conditioned by low interest rates according to the accepted wisdom). The relevant question is whether this regional fact is useful in describing a global condition. The savings glut theory is marvellously ambiguous in this area. How does one define conditions in the offsetting region? How does one define conditions globally? Oh, sorry. If rates are low, it’s a global savings glut.

Third, the notion of the savings glut is essentially useless beyond this. The much more important idea is how the regional excess savings has come about. And clearly, central banks have done that. The critical behaviour is that central banks have manipulated their exchange rates in order to generate a regional savings glut.

From here, one can argue that US consumers have fallen prey to the low import prices that have been induced by foreign central banks. Sure there’s a regional savings glut. But US consumers have made some contribution to enable it by spending beyond their means.

And the question of interest rate influence remains an open one. The savings glut thesis suggests that the role of the Fed was passive in the face of low interest rates from capital flows, and that the role of the US consumer was passive in the face of low borrowing costs and low prices. It suggests that conditions were really beyond the capability of the Fed to stop enabling liquidity or of consumers to stop borrowing beyond their means. The savings glut was the macro kool aid for suicidal consumer behaviour. Not a very attractive theory.

Posted by bsetserApril 23, 2008 at 8:09 am

Anonymous — what exactly would the "C -OMC" do? Stop buying euros? Sell Treasuries for Agencies? Buy up MBS to provide liquiudity to the housing market?

Logan — good points. Fan Gang has been making the argument that the dollar is a less-than-ideal reserve currency for a while, tis true. But he also has been keen on defending the peg (notably at the Peterson institute conference), which strikes me as a policy that reinforces the importance of the dollar in China’s portfolio. Do you have a sense as to whether China has been diversifying its portfolio in a significant way?

Posted by DCApril 23, 2008 at 8:42 am

Here is what former Fed Chairman Paul Volcker thinks of the "savings glut theory" by Greenspan and Bernanke that foreigners are responsible for Americans overspending habits:

Former Federal Reserve Chairman Paul Volcker agrees–and he wants spendthrift Americans to know they only have themselves to blame. "Financial crises do not happen in a vacuum and the current U.S. banking debacle is linked to imbalances in an economy that favored spending at the expense of saving," Volcker said. "You can’t go on forever spending more than you’re producing. You have to rely on unorthodox finance to sustain it." Volcker challenged the reliability of the mathematical models that economists and investors have come to rely on over the past few decades. "There’s a fascination with a lot of risk management tools that this situation has demonstrably proved false," Volcker said. Volcker warned US policymakers against inflating their way out of the credit crisis.

Posted by TwofishApril 23, 2008 at 11:11 am

Putting tariffs on Chinese goods or doing RMB revaluation won’t save American jobs, since all those jobs will just move to Mexico……

Posted by RebelEconomistApril 23, 2008 at 11:13 am

Brad,

I thought that the exorbitant privilege was more about enjoying relatively low interest rates (because of the additional source of demand for reserve currency debt) than the option of diluting your currency.

Like HZ (on 2008-04-22 19:28:52), I say that China cannot complain about losses due to exchange rate fluctuations around an underlying value of the dollar consistent with a reasonable degree of internal price stability (eg a depreciation against goods and services of about 2%), but they have every right to feel aggrieved (as have internal holders of dollars) if the Fed tries to inflate away the US financial problems (even if reported inflation is fiddled to obscure this policy). Unlike HZ, I can see the Bernanke Fed taking this course – I suspect that his willingness to do so is the main reason why he was appointed.

Posted by GuestApril 23, 2008 at 11:20 am

Did any one tell China that when they "pegged" their currency to others, they decided to manage their economy with one handed (the monetary policy hand) behind their back ?

Posted by AnonymousApril 23, 2008 at 11:49 am

the US is going to feed the chinese and world USD so we can enjoy our lifestyle. shut up ching chong and take your USD and be thankful. now make me some freaking nike shoes and plasma tvs. now.

Posted by RebelEconomistApril 23, 2008 at 12:12 pm

Guest on 2008-04-23 11:20:27,

I would imagine that Robert Mundell, who has been supportive of the Chinese currency policy, did. Those who accuse China of mercantilism forget that the peg that the Chinese finally let go in July 2005 had been in place since 1994, through 1997 when a floating renminbi might well have depreciated.

Posted by TwofishApril 23, 2008 at 12:16 pm

Guest: Did any one tell China that when they "pegged" their currency to others, they decided to manage their economy with one handed (the monetary policy hand) behind their back ?

Yes, but at the time the decision was made in 1993, the Chinese economy was very, very different. In 1993, the Chinese economy wasn’t nearly as embedded into the global market and it really didn’t have much of a system for determining monetary policy.

Also in 1993, the conventional wisdom in the West was that floating currencies were a very, very bad thing for developing countries since it was better for them to tie their monetary policy to the developed world.

Posted by TwofishApril 23, 2008 at 12:24 pm

This is one reason that I think it’s a bit unfair to blame China for being slow to reverse policy on the peg. There wasn’t appreciation pressure until 2003/2004, at which point China had to reverse about a decades worth of policy. Also the pressure to appreciate came I think directly from US tax cuts + the war in Iraq.

The big miscalculation wasn’t made in Beijing. No one in Washington in 2003 thought that the war in Iraq was going to be as long or as expensive as it it turning out to be, and the wealth to pay for it has got to come from somewhere.

Posted by RebelEconomistApril 23, 2008 at 12:26 pm

I forgot to explain that, at the time, the idea was to import the monetary stability of a well-managed, reliable economy. Oh dear!

Posted by ACApril 23, 2008 at 3:56 pm

The Chinese should simply think about the trillions of dollar reserves as a gift to their grandchildren. If this money will be spent on US goods in the future, then its value won’t be lost. The grandchildren of the current Chinese generation will compete with the American people for American food, for example, using that money.

What I don’t understand is why at least the Chinese can’t think more strategically about this dollar reserve. Even if this trillion dollar would be completely lost (as I said, it won’t be lost if it will be spent on American goods in the future), the gain in economic development and power that is made possible by the amassing of those dollars, will far outweigh any possible losses. The value of the economic development, the 10-20 million new jobs created every year, the 4-5 million new students at the universities every year, the 50 thousand PhD per year by 2010 (more than in the US) etc. is unimaginably high. China should simply forget to worry about its dollar reserves. If that is the price for economic development and power, then they should pay it without thinking for a second. It is a much better bargain than even the buying of Manhattan was.

Posted by GuestApril 23, 2008 at 6:56 pm

How can you say that the Chinese invest in Treasuries so they don’t lose money and then agree that investing in dollar denominated assets is a sure way to lose money due to the dollar’s depreciation. I would think buying into a business, in short buying stocks would be far wiser in the long run, even if the stocks go down short term, than investing in a depreciating currency that will likely never recover.

Posted by YukApril 23, 2008 at 9:00 pm

Twofish: "Public criticism and private criticism are very different things".

Except under a regime of censorship. What you call private criticm in China is only criticm that was let through by censors.

Twofish: "WTO, UN peacemakers in Lebanon, cooperation over North Korea says that you are wrong".

Iran, Darfur, Burma, Zimbabwe says that I am right. As regards WTO, we have obviously not the same reading of the ongoing debates and the role China plays…

Twofish: "The problem is that China is simply not willing to be part of a multilateral process if multilateral means that the West tells China what to do, and I don’t see anything wrong with that, and China really doesn’t have that much interest in telling the West what to do."

This idea is totally wrong and feeds the misunderstanding between Emerging and Industrialzed countries. OECD, IMF, World Bank are actually being reformed and these reforms are clearly inteded to enhance Emerging countries’s participation, in particular China’s. Even before that, EM like China held a sufficient power to at least influence the debate.

I am not saying that factors of modernization and moderation are not existing in China. Reformist are cleraly a major component of the Chinese Communist Party, which is far from being the monolithic body it seems. This being said, the conservative component remains very strong indeed and is well represented at the highest level of the State and of the CCP. These guys are the ones which keep a hard stance in Foreign Affairs as well as on issues like FX regime – no macroeconomic principle behind that, only political, to PBoC’s utter despair. These guys are the ones who really do disservice to China’s international image by sticking to Maoist rethoric despite the tremendous changes their country has been going through. Plenty of examples these days. Keep in mind that these Conservatives are still in, and powerful, and that they are engaged in a struggle against the Reformists, within the CCP.

Posted by TwofishApril 23, 2008 at 10:10 pm

Yuk: What you call private criticism in China is only criticism that was let through by censors.

By private criticism, I mean when a government official sits down with you and asks you what you really think.

Yuk: OECD, IMF, World Bank are actually being reformed and these reforms are clearly inteded to enhance Emerging countries’s participation, in particular China’s. Even before that, EM like China held a sufficient power to at least influence the debate.

So of what use to China would be more say in OECD, IMF or the World Bank? As discussion forums, think tanks and academic exchanges work better. China has enough economic ability to prevent the World Bank and IMF from taking policies against the Chinese national interest. As far as aid to emerging nations, China has the money to do things bilaterally.

I really don’t see the point of increased Chinese participation in IMF or the World Bank. There does need to be a discussion of the international banking system, but that should probably take place through the Basel II framework and the BIS which China is a member of.

Yuk: This being said, the conservative component remains very strong indeed and is well represented at the highest level of the State and of the CCP. These guys are the ones which keep a hard stance in Foreign Affairs as well as on issues like FX regime – no macroeconomic principle behind that, only political, to PBoC’s utter despair.

That analysis is dangerously wrong. Viewing Chinese politics as "evil conservatives" versus "good reformers" is just not the way Chinese politics. The fact that someone is in favor or against a floating currency tells you ***absolutely nothing*** about their views on Taiwan, privatization of industries, liberal democracy, or their views toward Mao Zedong. Assuming that people in China fall into two groups.

Someone can think that China should be very confrontational with the US about Tibet, somewhat non-confrontational about Taiwan, hate Mao, like Marx to some degree, oppose industrial privatization, be in favor of currency liberalization, be moderately against a maxi-revaluation. Like me for example. Am I a conservative or a reformer?

And you can find someone else, ask them the same sets of questions, and find that people just don’t cluster in two groups.

Posted by YukApril 24, 2008 at 4:39 am

Twofish: "Someone can think that China should be very confrontational with the US about Tibet, somewhat non-confrontational about Taiwan, hate Mao, like Marx to some degree, oppose industrial privatization, be in favor of currency liberalization, be moderately against a maxi-revaluation. Like me for example. Am I a conservative or a reformer?"

I’d say you’re probably not a NDRC guy and I’d say if you’re a member of the CCP Standing Committee, bad news: your promotion has been postponed!

More seriously, I definitely know there is no clear cut between "reformists" and "conservatives". I certainly do not want to slip into such manicheism. Nonetheless, there are well-known lobbies which can be boradly attached to one or the other. My purpose is most of all to underline the existence of a strong conservative line at the highest level, which impact all decision taking process, be it political or economic.

Posted by Judy YeoApril 24, 2008 at 7:43 am

Brad

Have to admit, haven’t read the rest of the responses, so apologies in advance if this is a repeated question. The willingness to allow debtors to pay in the creditors’ home currency might not well be in the control of the creditor for at least 2 reasons; the creditors might not, at the origin of that debt, been nable to enforce repayment conditions or to establish them in the first place, more importantly, debt covenants can only exist if the debt is official, China’s lending/funding of the USA is hardly in the form of an official, traditional debt. Curiously enough, the USA has become the greatest debtor in more ways than one; it is one debtor that dictates to its creditors(the rest of the world) and reserves all rights to modify all conditions of repayment and its creditors are clamouring to lend it money ; can you hones6tly blame the banks for their "infallibility belief"?

Honestly, Chinese investment in euros looks like a sure bet to lose but well, mebbe they have sharper minds; well they are paying them lots more, so their minds should be sharper!

Posted by TwofishApril 24, 2008 at 9:04 am

Yuk: Nonetheless, there are well-known lobbies which can be broadly attached to one or the other.

There certainly are well-known lobbies, but it is very misleading and dangerous to group those lobbies together. At the highest levels, you can broadly classify people based on whether they have an "interior" outlook or a "coastal" outlook, and there is an effort to balance the two broad groupings.

Personally, I think it would be a disaster if you had one faction "win" since having two broad tendencies within the Communist Party creates something more or less akin to an internal multi-party system.

Yuk: My purpose is most of all to underline the existence of a strong conservative line at the highest level, which impact all decision taking process, be it political or economic.

And my point is that I think that thinking in terms of a conservative/reform dichotomy is highly misleading. In particular, there is the assumption that "reformers" are less nationalistic and less committed to the continuation of one-party rule than "conservatives" and that’s just not the case.

Someone from the PBC is much more likely to think that China should control inflation via interest rates than someone from the NDRC. But that tells you nothing about their views on foreign policy, and also, maybe the PBC is wrong, and NDRC is right.

Posted by GuestApril 24, 2008 at 3:59 pm

Yuk:

I suspect that "these guys" in China don’t much care what you think about their internal arrangements. China resents, although it is not strident about it, "advice" re its internal affairs from the West that used to interfere mightily in its internal affairs. Tired of imperialism, China is not about to listen to your complaints. So you can keep on talking to yourself if you want. Go ahead, but don’t expect the Chinese to listen or care.

Posted by TwofishApril 24, 2008 at 4:20 pm

Guest: China resents, although it is not strident about it, "advice" re its internal affairs from the West that used to interfere mightily in its internal affairs.

Chinese government officials and most Chinese are quite happy to listen to advice in the form of constructive criticism. It’s when the tone turns into "you idiots, we know how to run your country better than you do, and we’ll force you to do the right thing for your own good" that you get a bad reaction.

Posted by donApril 24, 2008 at 5:35 pm

HZ:

"I think the vast majority of Chinese don’t know or care about the nominal loss of the reserve in exchange rate (unless it is sensationalized as an one-sided loss). Unlike oil from OPEC, labor can not be stored."

Volcker (Via DC):

"Financial crises do not happen in a vacuum and the current U.S. banking debacle is linked to imbalances in an economy that favored spending at the expense of saving … You can’t go on forever spending more than you’re producing. You have to rely on unorthodox finance to sustain it."

These are cogent observations.

Posted by donApril 24, 2008 at 10:10 pm

Judy Yeo:

‘Honestly, Chinese investment in euros looks like a sure bet to lose but well, mebbe they have sharper minds; well they are paying them lots more, so their minds should be sharper!’

Reasons China might buy euros, besides the interest rate differential or (I hope) misguided fears that the U.S. will eventually renege on its debts:

The U.S. economy is turning down. Its workers might start to resent being put out of jobs by subsidized imports if things get too bad. So, even though yuan spent on euros won’t buy as much as yuan spent on dollars, China may be looking for other currencies to buy to keep up its exports. The yen is quite cheap now. One wonders why China wouldn’t buy more of them, despite the current low interest rate. My suspicion? They know they would face some sharp objections from Japan.

Posted by BillMay 1, 2008 at 8:30 am

This just shows that Chinese don’t know a thing about monetary policies. Government actions should "stabilize" the currency in terms of rate of rise and fall, not the level where it is at. Currencies are suppose to find their own level naturally in the market.